Do we need auditors?

13 March 2019

In some recent high-profile business failures the finger of blame has been levelled at the auditors. An auditor’s work is poorly understood, but many think that they know what it should achieve. Led by Government, change is on the way. So what will the auditing profession look like in a few years’ time?

Auditors under the spotlight

Auditors have recently been in the news for all the wrong reasons. In the last year or so I have written twice about high-profile cases in which the auditors’ role has been questioned, see my blogs on Patisserie Valerie, and on Carillion . In the former case the auditors are accused of failing to detect a massive fraud, in the latter another audit firm was criticised for failing to realise that the company was not a going concern.

So what is auditing and why is it failing to meet the expectations of the public and the Government? Not so long ago the term ‘audit’ was used loosely to indicate the fact that a company’s accounts had been prepared by a qualified accountant. In those days all limited companies, no matter how small, were legally obliged to have their financial statements audited. It was the quid pro quo for the enjoyment of the benefits of limited liability. Nowadays only large organisations, or those subject to specific regulatory oversight, are required to have their financial statements audited.

Assurance

An audit is the examination of an organisation’s annual financial statements, carried out by a properly authorised and independent person. Its purpose is to issue an opinion as to whether those financial statements present a true and fair view of the organisation’s results for the year and of its position at the accounting date, and are free of material misstatement, whether due to fraud or error. The audit also gives assurance on whether the financial statements comply with all relevant accounting standards and legislation.

Risk assessment

Auditing is primarily an exercise in risk assessment so the auditor’s first task is to gain an understanding of the organisation’s activities and the industry in which it operates; secondly to identify and evaluate the potential impact of any risks which might affect the organisation’s financial position or performance; then to examine and assess the effectiveness of the internal controls that the organisation has put in place to mitigate those risks. These controls are then tested by statistical sampling to ascertain whether they are effective in practice. Work carried out will also include:

examining financial records and other documents and seeking verbal assurances, third party confirmations, etc.

obtaining evidence that all liabilities are included in the accounts

checking assets included in the accounts for existence, ownership and value

checking the validity of estimates or assumptions that management made in preparing the financial statements, (which will include the assumption that the company is a going concern.)

Fraud detection?

There is an ongoing debate about the responsibilities of the auditors in the Patisserie Valerie case. Called before a committee of MPs the senior partner of the company’s auditors said, “We are not looking for fraud and we are not looking at the future and we are not giving a statement that the accounts are correct. We are saying they are reasonable …….” No doubt he was relying on the 1896 case of Kingston Cotton Mill where the judge famously ruled that the auditor “is a watchdog, not a bloodhound”. However, various reports, including one by the Financial Reporting Council, indicated that the company’s accounts contained significant irregularities caused by fraud and that the directors claimed to be unaware of these. So the financial statements were not free of material misstatement caused by error or fraud, and the company’s internal controls were inadequate. It is hard to see how the auditors will be able to defend their opinion.

We are all stakeholders

If auditing does not fulfil its function the public ought to be concerned. Company directors have a statutory duty to act in the interests of all their stakeholders. These comprise investors, lenders, suppliers, customers and employees. It is when employees lose out that newspapers become most vociferous, especially when the company’s pension scheme turns out to be underfunded as in the cases of Carillion and BHS. But all of those who have private pension schemes are affected when companies, whose shares are owned by pension funds, fail.

More competition means more confidence

Auditing in the UK is heading for a shake-up. Many smaller firms of chartered accountants have audit licences and audit mostly private companies, but the audits of companies quoted on the Stock Exchange are carried out almost exclusively by just four multinational groups. This unhealthy lack of competition is made worse by the fact that each of these four groups provides consultancy services to those companies that aren’t their clients. All of this is now the subject of parliamentary scrutiny. Even the FRC, the body that sets and enforces auditing standards, and (via the accountancy bodies) regulates and licenses audit firms, is likely to be replaced. What we may see is a requirement for auditors to be rotated more frequently and more restrictions on the provision of consultancy services that are perceived to cause conflicts of interest. The aim should be to open the market in auditing public companies to a much wider range of firms, but the difficulty is that few would have the capacity to audit the global giants, so this could only be achieved by some arrangement to share audit assignments. Parliament will insist that regulation and monitoring, already quite strict, become a great deal more effective. We should welcome this because without such measures high-profile errors will continue to hit the headlines and the public will increasingly ask if auditing has any value.

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